Central Bank Credibility: The Next Bubble to Burst?
Central Bank Credibility: The Next Bubble to Burst?
A prediction for 2023.
A theme of The Fiat Cave Newsletter has been analyzing the central-bank-driven "boom-bust" economic cycles and their consequences, which disproportionately impact the middle class. This piece will discuss the bubble in central bank credibility and how it likely will burst.
The Credibility Bubble
Central banks manipulate the benchmark interest rate to attempt to "smooth the business cycle." Central banks will increase or decrease interest rates depending on where the economy is in this economic cycle.
For instance, when a recession hits, which is simply economic contraction, central banks lower interest rates to encourage more borrowing, spending, and investment. Sounds nice in theory. The central banks attempt to use interest rates to reduce the pain felt from recessions.
The issue is that each recession has been met with lower interest rates and more debt issuance. Since the 1980s, the Federal Funds Rate has been in a secular downtrend toward 0%.
In response to the 2008 Great Financial Crisis, the Federal Reserve lowered interest rates to 0% and introduced Quantitative Easing (money printing.) The combination of 0% interest rates and QE stayed in place in Western economies for several years after the financial crisis. As a consequence, these artificial interest rates and easy money policies created a bubble in assets following the Great Financial Crisis. Simply because assets are valued off of interest rates, artificially lowering that discount rate will artificially raise asset values.
The continuation of the easy money policy was justified because there was not much inflation in the real economy, measured by CPI. The lack of inflation was enough to justify their continuation of 0% interest rates and money printing. It's safe to say that markets became accustomed to the Zero Interest Rate Policy (ZIRP) and QE Post 2008. There is a clear difference in the rate of return in markets pre and post-2008, which was not driven by economic growth but simply by artificially low rates and money printing. Although there was no inflation in the real economy measured by CPI, asset prices certainly became inflated.
Fast forwarding to 2020, as the virus took the world by storm, financial markets panicked, pricing in the worst-case scenario. There was a massive sell-off, even in US Treasuries, as all types of investors were scrambling to hold dollars rather than assets. Central banks and governments globally embarked on the most aggressive monetary and fiscal policy ever seen. Rates were lowered to 0%, and there was an unfathomable amount of money printing. Unlike 2008, the policy response created inflation, and not mild inflation, but the highest inflation in forty years.
When the CPI started to tick higher, it was not surprising because, in the US alone, they printed $6.4 trillion, which was a 42% increase in the money supply.
The issue is not only the inflation that the central banks and governments have created but also the fiscal situation they have created for themselves. After decades of lower interest rates and more debt, the balance sheets of nation-states globally are quite a mess. The United States, for instance, has racked up $31 trillion of federal debt, making the federal Debt-to-GDP ratio roughly 120%. When considering all government-issued debt in the US, it is 135%.
The excessive amount of debt in the system now complicates and jeopardizes central banks' ability to raise interest rates to fight inflation. Again, to make sure we are on the same page, just as central banks will lower rates during a recession to try to spur economic activity when inflation is running hot, they raise rates to try to slow down economic activity.
Now, because of the inflation that central banks and governments have created and their decisions to always lower interest rates and print more money in each recession, they find themselves in a precarious situation. In each economic downturn before, they were seen as heroes who were able to save the economy from calamity through easy money, but not without its costs.
As we have seen in 2022, the Federal Reserve has led the charge on hiking rates and (minimal) Quantitative Tightening to attempt to combat the high inflation we are experiencing. But as we covered in detail in "The Fed's Big Decision: Destroy the Middle Class or Destroy the Middle Class (Part 2),” the Federal Reserve, as the central bank of the world, faces its biggest challenge yet. While the campaign to tighten financial conditions has gone smoothly, outside of the bloodbath in financial markets, that may not be the case for much longer.
Eventually, they will have to face reality. Due to the fiscal situation of nation-states globally, namely their exorbitant Debt-to-GDP ratios, higher interest rates will not be sustainable. The combination of higher interest expense and higher entitlement payments with lower tax revenues poses a threat to the US government's solvency. A debt spiral is on the horizon, as we detailed in our last piece.
The impending debt spiral could burst the next major bubble, central bank credibility.
The Emperor Has No Clothes
We know this is not a consensus view. The mainstream view of the current macroeconomic landscape is the following: "Central Banks will tighten financial conditions and keep them tight until inflation has been subdued by their heroic efforts." However, traditional analysts fail to look behind the curtain.
Wall Street is quick to compare Jerome Powell to Paul Volcker, the Fed Chairman, who stomped out the inflation of the 1970/80s. He raised the Federal Funds Rate to 20% in 1981 (for comparison, today it's 4.50%). Volcker's fight against inflation was successful, but not without its costs. Inflation fell below 3% by 1983, but unemployment rose to over 10%.
The core difference between the situation during Volcker's time and today is the leverage in the financial system. At the time of Volcker's fight against inflation, Debt-to-GDP was approximately 35% compared to 135.5% today. The current situation is fundamentally different from the 1980s because of the debt in the system, and that is what most people miss.
We believe that in 2023 the reality will set in. But what does that mean exactly?
Our expectation is that sometime next year, the fight against inflation led by the Fed will be lost. Because of the threat of the debt spiral, central banks globally will be forced to abandon its offensive against inflation and will be forced to lower interest rates and begin printing money. Should inflation, measured by CPI, still be materially above the 2% target when this happens as we expect, that will be a humiliating loss for the central bankers.
Abandoning their fight against inflation while CPI is still elevated will be an admission that they have lost control of the financial system.
At that moment in time, the biggest bubble of them all, central bank credibility, could burst. It would be clear that the "emperor has no clothes."
The common belief that the Federal Reserve is an omnipotent entity that stabilizes our economy through a balance between "maximum employment and stable prices" would be jeopardized. An unsuccessful campaign against the highest inflation in forty years would raise questions about their ability to manage the economy.
Not only that, but their inability to reduce inflation would stoke fear and uncertainty for the future. If inflation is not brought down from already elevated levels and money printing begins again, then what does that mean for the future? That would be a recipe for disaster. The combination of money printing and loss of faith in the central bank would result in higher inflation, as gradually, then suddenly, people realize there is no way out of the mess they have created.
The Central Bank Hedge: Propaganda & Crisis
It is inevitable that central banks will be lowering interest rates and printing money in due time; however, it is possible that despite their defeat in the war against inflation, they can save their credibility. It would be naive to think that these glorified counterfeiters would allow their reputations, which have been built up over a century, to evaporate without a fight. But how could they possibly save their reputation while obviously throwing in the towel against inflation? Propaganda and crisis.
Central banks are the master of propaganda. They have successfully brainwashed the public to believe that "moderate inflation" is both natural and healthy for an economy. Their "mostly peaceful" heist of currency debasement has gone largely unquestioned for several decades.
The path of least resistance would be an update to their inflation target, which would not be that abnormal. The 2% target inflation rate was arbitrarily decided to begin with and was changed again in 2020 to "2% on average over time." There are already rumblings of higher inflation targets and an increase in media reporting that inflation is actually good for you!
Since the official inflation target is merely a balance between stealing as much money as possible from productive members of society and not raising many questions from the public, it would not be surprising to see an increased target next year. Central banks will simply enlist their propaganda arm, the media, to push narratives to justify it and persuade the public.
We believe another likely development next year will be more crises and war. The emergence of a new crisis or war, kinetic or non-kinetic, seems plausible, given the circumstances. Around the time central banks have to abandon their inflation crusade, we would not be surprised to see another crisis emerge. That crisis would be used to justify the lower interest rates and money printing. It also may not necessarily need to be a "war" such as a kinetic war or the "war" on COVID. Perhaps the crisis is as simple as financial instability somewhere in the world that is deemed "too big to fail." The bottom line is that to maintain credibility with the masses, the Federal Reserve and other key central banks will need a reason to warrant their actions.
Through a combination of propaganda and crisis, it's in the realm of possibility that central banks are able to delay further the inevitable bursting of their credibility bubble.
Your Hedge Against the Credibility Bubble
But should central banks be unsuccessful in preserving their reputation, then we should anticipate the collapse of many currencies around the world. For those currencies that do not outright collapse, there would still be a massive devaluation, resulting in a loss of purchasing power for savers. According to author Saifedean Ammous, in his book "The Fiat Standard" "More than sixty episodes of hyperinflation have taken place in countries using fiat monetary systems in the past century."
We anticipate that number will increase next year. We do not expect hyperinflation in countries like the United States, but we do expect inflation to remain elevated and potentially increase as money printing is ramped up.
It's hard to say exactly how the next year will play out, but we do expect that because of the looming debt spiral, central banks will lose their fight against inflation and be forced into a corner of money printing. Now it's mainly a question of their ability to manage the narrative around that development. Will the central bankers be able to save their credibility, or will the bubble finally pop?
We would rather not take the chance either way. We favor hard assets that cannot be devalued because, regardless, there will be more currency debasement globally. All roads lead to fiat currency devaluation.
Our conviction remains strong in bitcoin, which we believe will be the fastest horse in the race to protect against the race to debase fiat currencies.
After all, Satoshi Nakamoto called the bluff of central banking and created an alternative to the theft-based fiat monetary system.
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